Can we dodge a recession? Many consumers feel poor

Business was already down at the Muddy Cup Coffee House this year. Now, Jim Svetz, owner of nine coffee shops in Upstate New York, fears things are only going to get worse.

Consumers "see the news, it's big news, it ends up being on the major news channels, and then everyone becomes worried, and it affects their spending," Svetz says. "It's very tough out here."

The U.S. economy has largely been resilient since the financial turmoil began more than a year ago, continuing to grow, albeit at a more subdued pace than in prior years. While some economists predicted the economy was headed for recession, others expected the USA would stay above water. But many economists think the latest chapter in the credit crunch saga, despite the government actions, will be too much for the economy to take, finally driving the USA into its first official downturn in seven years. Action by government in recent days may only soften the already heavy blow.

"The economy is set on a course for a deeper recession" after the last few weeks, says Allen Sinai, president of Decision Economics. He predicts the unemployment rate will climb to near 7.0% from 6.1% in August.

"We're in a danger period for the next six or eight months," until house prices are expected to bottom, Carnegie Mellon economics professor Marvin Goodfriend says.

Recession is no sure thing, though. The market turmoil has led to a few developments that could keep the economy growing. Petroleum prices have fallen sharply from their July peak amid expectations for decreased demand in a slowing economy. And mortgage rates have fallen, making it easier for creditworthy customers to refinance their mortgages and reduce their payments.

"There are a lot of offsetting things going on here," JPMorgan Chase senior economist James Glassman says, noting that for the past year consumers have kept spending despite the broader financial issues.

Before last week's market upheaval, the U.S. economy was already slowing substantially during the second half of the year as a drop in consumer spending and an easing in export growth provides less support. Housing continues to act as a drag. Employers are consistently shedding jobs.

The stock market has lost $3.5 trillion of its value since its most recent peak last October. And Americans have seen more than $1 trillion in real estate wealth disappear from the peak hit a year ago, according to Moody's Economy.com.

Now, the frenzy in financial markets has led to the bankruptcy filing of investment bank Lehman Bros., government takeovers of Fannie Mae, Freddie Mac and insurer AIG, and a $700 billion proposal to shift bad bank assets to government.

Those actions could take a toll on confidence as Americans are bombarded with headlines of an economy under duress, people worrying about their money and investors yanking cash out of what were previously considered safe investments. In addition, credit is expected to become even tighter, making it harder for companies and individuals to access the cash needed to make investments and everyday purchases.

Bob Lubell, owner of Grand Lubell Photography in Sylvania, Ohio, notes that consumers were already hesitant before the past few weeks. Weddings are being booked weeks, not months, in advance. Brides and grooms are cutting a few corners, driving their own cars rather than taking limos, having more casual rehearsal dinners and forgoing pricey cakes. Twice recently he's seen cash bars, something generally unheard of at weddings he's familiar with.

He's concerned that what has happened in the past few weeks will cause consumers to feel "emotional loss" even if it does not affect their pocketbooks directly. That may lead them to cut back further. "I fear very difficult times ahead," he says.

Consumers

Wall Street's problems could hit Main Street in several ways:

•Confidence. Government bailouts, wild stock market swings and companies going under beget worrisome headlines. "I don't know how we get through this without a significant psychological blow," says Moody's Economy.com chief economist Mark Zandi. He says wealthier consumers who watch the stock market are likely becoming less confident. The same is true for older Americans who have seen rates on certificates of deposit drop significantly from last year.

Although the Conference Board reading of consumer confidence ticked higher recently, it still was far below the level seen a year ago heading into this month's financial frenzy. Consumer spending accounts for more than two-thirds of all U.S. economic activity. Even before the recent market events, consumer spending was slowing. Two retail groups last week predicted the holiday shopping season would show the smallest gain in sales since 1991. If spending were to actually decline this quarter or next, it would be the first time since 1991, when the U.S. economy was in a recession.

Business confidence also might take a hit, making companies less willing to invest and hire, Zandi says.

Xerox CEO Anne Mulcahy says U.S. businesses have generally been hesitant in decision-making, and recent market events mean that hesitancy will likely last longer than earlier expected.

"What you do have is a very nervous business environment in the U.S.," she says.

•Wealth. Despite a powerful rally on Wall Street late last week, investors are still sitting on massive losses — some of them on paper — as the result of the ongoing bear market.

The S&P 500 is still 20% below its high of 1565.15 on Oct. 9, 2007. That means it's still in bear market territory, unofficially defined as a 20% or more decline.

"What we've seen happen is a massive loss of wealth. That's important, in that it now says equities are right there alongside housing prices in eroding household net worth," National City economist Richard DeKaser says.

The Federal Reserve said last week that U.S. household net worth fell in the quarter ended June 30 to the lowest since 2006 as the value of Americans' real estate and stocks dropped, and their bank accounts shrank. When consumers see their wealth decline, they are more likely to try to save money and hunker down.

•Credit. Anxiety in financial markets means banks will likely be even more cautious when it comes to making loans.

"There's just too much of a cold shower out there to expect anything but tighter credit conditions now," says Brian Bethune, director of financial economics at Global Insight.

Tighter credit means consumers have a tougher time financing big purchases such as large-screen TVs and cars, and small items bought with plastic. It also makes it harder for businesses to expand or to even carry on day-to-day operations.

Svetz, of the Muddy Cup Coffee House, shelved plans to expand, in part because of the economy, but also because when he approached banks, he got the cold shoulder. That's a big difference from just a few years ago, he says. "We asked one of our banks, and they just kind of looked at us like we were crazy," he says. "Getting credit for small businesses is nearly impossible these days."

•Jobs. Bank closures and consolidation in the industry means people are losing their jobs. The meltdown could cost Wall Street up to 40,000 jobs, according to an estimate last week by New York state government.

When someone loses a job, they scale back their spending. That affects the restaurant owner who loses a regular Friday night diner, the dry cleaner who no longer has suits to clean, and the hair dresser whose client stretches out the time between visits.

Silver linings?

There is some good news.

•Inflation. After rising at the fastest pace in decades earlier this year, inflation is easing.

Oil closed above $100 a barrel on Friday for the first time in a week, but it's still 28% below its record close on July 3.

While gasoline prices have risen in the past week because of supply issues related to Hurricane Ike, the price at the pump should ease soon, giving drivers a break. Heating costs and other energy prices should also not be as bad as earlier projected, the government says. That will put more spending money into consumers' pockets.

"We've already seen consumer prices fall in the month of August, and they almost assuredly will again in September," DeKaser says. "This is unwinding the tax-like increase that commodity prices posed at the beginning of the year."

•Mortgage rates. Mortgage rates have dropped following the government decision this month to place giant investors Fannie Mae and Freddie Mac into conservatorships.

The nationwide average price for a 30-year fixed mortgage was 5.78% last week, down from 5.93% in the prior week and the lowest since mid-February.

While many people will have problems obtaining a loan, those whose credit is in good shape will be able to refinance their mortgages, likely lowering their monthly payment. The Mortgage Bankers Association's refinancing index was up 88.1% during the week ending Sept. 12.

"One of the best ways to make lemonade out of this mess is to refinance your mortgage," Wachovia senior economist Mark Vitner says.

•Global growth. Although economies abroad, particularly in Europe, are slowing, a number of countries are still going strong, providing a boost to those that export to customers in those nations and that do business there.

Overseas sales allow Xerox to "ride out the storm," Mulcahy says.

Likely in part because of the uncertainty of the rapidly evolving situation, the Federal Reserve last week left its short-term interest rate target unchanged, arguing the broader actions being taken should help prop up the economy. With inflation easing, the Fed now has more room to cut rates to boost the economy.

"The Fed has the capacity now to think more about the downside risks," Goodfriend says.

Wachovia's Vitner says it's possible the economy could make it through OK: "If we can make it through the next three months with any economic growth at all, then we might avoid an outright recession. That would be one of the most miraculous jobs that the Federal Reserve has ever pulled off."